Exam 20: Management Compensation, Business Analysis, and Business Valuation

The King Mattress Company had the following operating results for 2018-2019. In addition, the company paid dividends in both 2018 and 2019 of $60,000 per year and made capital expenditures in both years of $30,000 per year. The company's stock price in 2018 was $8 and $7 in 2019. The industry average earnings multiple for the mattress industry was 9 in 2019 and the free cash flow and sales multiples were 18 and 1.5, respectively. The company is publicly owned and has 1,200,000 shares of outstanding stock at the end of 2019. $\text { Balance Sheet, Dec 31, }$ 2019 2018 Cash \ 340,000 \ 100,000 Accounts Receivable \ 350,000 \ 400,000 Inventory \ 250,000 \ 300,000 Total Current Assets \9 40,000 \8 00,000 Long-lived Assets 1,080,000 1,100,000 Total Assets \2 ,020,000 \1 ,900,000 Current Liabilities \2 00,000 \3 00,000 Long-term Debt 600,000 500,000 Shareholder Equity 1,220,000 1,100,000 Total Debt and Equity \2 ,020,000 \1 ,900,000 $\text { Income Statement, for year ended Dec } 31 \text {, }$ 2019 2018 Sales \ 4,750,000 \ 4,500,000 Cost of Sales 4,100,000 4,000,000 Gross Margin 650,000 500,000 Operating Expenses 350,000 400,000 Operating Income 300,000 100,000 Taxes 120,000 40,000 Net Income \1 80,000 \6 0,000 Cash Flow from Operations 2019 2018 Net Income \ 180,000 \ 60.000 Plus Depreciation Expense 50,000 50,000 + Decrease (-inc) in AccRec. and Inv. 100,000 - + Increase (-dec) in Cur. Liabl. (100,000) - Cash Flow from Operations \2 30,000 \1 10,000 The value of the company, calculated using the earnings multiple for 2019 is:

The receivables turnover ratio is a measure of:

The objectives of management compensation, when compared to the objectives used to develop performance measurement systems, are:

Corona is a privately held high-end luxury retailer that operates stores in the wealthiest cities and suburbs in the United States. The corporate headquarters is located in New York City. The company has a long history of profitability and a strong national image as the pinnacle of luxury. However, in the past two years Corona's profitability has begun to drop off and many of the top executives fear that the company's most important asset, its brand image, might come into jeopardy if it cannot regain its past profitability. Bernard Starnes, Corona's long-time CEO, wonders if the company's aged compensation plan might be at least partially responsible for Corona's tough times. He remembers a time when the company was rapidly expanding by creating several new divisions and aggressively promoting its brand image. It seemed like he was attending a new store opening every week. During those times divisional managers worked hard for their bonuses. It was almost as if there was a competition between divisions as to which could beat their sales plans by the widest margin because that would mean the largest bonuses. This was due to the fact that a significant portion of the managers' compensation was tied to their bonuses. Now the company is not expanding as rapidly and its focus has shifted to promoting current products and growing same-store sales. Furthermore, Mr. Starnes has noticed several troubling trends within the company. First, he has noticed a steady decline in cross-divisional cooperation and coordination. Second, there have been several recent occasions where Mr. Starnes had to become personally involved in situations where divisional managers were making decisions that were beneficial to their individual divisions but not strategically aligned with the firm as a whole. Finally, management turnover is becoming somewhat of a problem, especially right after bonuses are awarded at the end of each fiscal year. Required: Suggest a new compensation plan that would help solve the problems Mr. Starnes has noticed at Corona. Show how your answer effectively addresses the strategic goals of the company.

Products Inc. manufactures furniture and is organized into three large divisions: bedroom, living room, and dining room furniture. The following information presents operating revenues, operating incomes and invested assets of the company over the last three years. (all figures in 000s) Operating Revenue Operating Income Invested Assets Dining Room 2018 \ 8,000 \ 2,500 \ 12,000 2019 16,000 4,100 12,500 2020 16,000 1,800 12,500 Living Room 2018 4,500 450 2,500 2019 4,600 800 2,400 2020 2,400 600 2,200 Bedroom 2018 8,800 1,200 4,500 2019 8,600 1,800 4,700 2020 6,600 1,600 4,900 The following table shows the number of managers covered by the current compensation package of Products Inc.: Number of Executives Dining Room Living Room Bedroom Total 2018 300 40 120 460 2019 350 40 140 530 2020 375 37 175 587 The current compensation package is an annual bonus award. The managers share in the bonus pool. The pool is calculated as 12% of the annual residual income of the company. The residual income is defined as operating income minus an interest charge of 10% of invested assets. Required: (1) Use investment turnover, return on sales, and ROI to explain the differences in profitability of the three divisions for 2018, 2019 and 2020. (2) Compute the bonus amount to be paid during each year. Also, compute the average individual executive bonus amounts (round to even dollar). (3) If the bonus were calculated by divisional residual income what would be the bonus amounts for each division? (4) Discuss the benefits and problems of basing the bonus on firm-wide residual income of a company compared to using divisional residual income.

Economic value added is calculated from:

Which one of the following develops the value of the firm as the present value of the firm's net free cash flows?

Firms typically provide benefits (perks) to employees to enhance motivation.Which of the following would not be an example of a perk?

The King Mattress Company had the following operating results for 2018-2019. In addition, the company paid dividends in both 2018 and 2019 of $60,000 per year and made capital expenditures in both years of $30,000 per year. The company's stock price in 2018 was $8 and $7 in 2019. The industry average earnings multiple for the mattress industry was 9 in 2019 and the free cash flow and sales multiples were 18 and 1.5, respectively. The company is publicly owned and has 1,200,000 shares of outstanding stock at the end of 2019. $\text { Balance Sheet, Dec 31, }$ 2019 2018 Cash \ 340,000 \ 100,000 Accounts Receivable \ 350,000 \ 400,000 Inventory \ 250,000 \ 300,000 Total Current Assets \9 40,000 \8 00,000 Long-lived Assets 1,080,000 1,100,000 Total Assets \2 ,020,000 \1 ,900,000 Current Liabilities \2 00,000 \3 00,000 Long-term Debt 600,000 500,000 Shareholder Equity 1,220,000 1,100,000 Total Debt and Equity \2 ,020,000 \1 ,900,000 $\text { Income Statement, for year ended Dec } 31 \text {, }$ 2019 2018 Sales \ 4,750,000 \ 4,500,000 Cost of Sales 4,100,000 4,000,000 Gross Margin 650,000 500,000 Operating Expenses 350,000 400,000 Operating Income 300,000 100,000 Taxes 120,000 40,000 Net Income \1 80,000 \6 0,000 Cash Flow from Operations 2019 2018 Net Income \ 180,000 \ 60.000 Plus Depreciation Expense 50,000 50,000 + Decrease (-inc) in AccRec. and Inv. 100,000 - + Increase (-dec) in Cur. Liabl. (100,000) - Cash Flow from Operations \2 30,000 \1 10,000 The gross margin percentage for 2019 is (rounded):

The Harrison Bicycle Company had the following operating results for 2018-2019. In addition, the company paid dividends in both 2018 and 2019 of $80,000 per year and made capital expenditures in both years of $230,000 per year. The company's stock price in 2018 was $14.20 and $12.50 in 2019. Also in 2019, the industry average earnings multiple for the bicycle industry was 8 and the free cash flow and sales multiples were 16 and 1.35, respectively. The company is publicly owned and has 1,400,000 shares of outstanding stock at the end of 2019. $\text { Balance Sheet, Dec 31, }$ 2019 2018 Cash \ 267,000 \ 100,000 Accounts Receivable \ 525,000 \ 400,000 Inventory \ 450,000 \ 300,000 Total Current Assets \ 1,242,000 \ 800,000 Long-lived Assets 1,205,000 1,100,000 Total Assets \2 ,447,000 \1 ,900,000 Current Liabilities \5 00,000 \5 00 Long-term Debt 600,000 500,000 Shareholder Equity 1,347,000 1,100,000 Total Debt and Equity \2 ,447,000 \1 ,900,000 $\text { Income Statement, for year ended Dec 31, }$ 2019 2018 Sales \ 6,250,000 \ 5,450,000 Cost of Sales 5,125,000 4,400,000 Gross Margin 1,125,000 1,050,000 Operating Expenses 580,000 550,000 Operating Income 545,000 500,000 Taxes 218,000 200,000 Net Income \3 27,000 \3 00,000 Cash Flow from Operations 2019 2018 Net Income \ 327,000 \ 300,000 Plus Depreciation Expense 125,000 125,000 + Decrease (-inc) in AccRec. and Inv. 7(275,000) - + Increase (-dec) in Cur. Liabl. 200,000 - Cash Flow from Operations \3 77,000 \4 25,000 The value of the company, calculated using the free cash flow multiple for 2019 is:

) A leading author in accounting and finance, Alfred Rappaport focuses in his work on the importance of a firm's management continually taking steps that increase shareholder value. In a recent article he set out his "Ten Ways to Create Shareholder Value:" ● Do not manage earnings or provide earnings guidance; do not focus on earnings as it reflect neither the company's value or the change in value over the reporting period. ● Make the strategic decisions that maximize expected value, even at the expense of lowering near-term earnings; this may mean divesting units that do not contribute to the company's long-term strategic goals though they do contribute to current profits. ● Make acquisitions that maximize expected value, even at the expense of lowering near-term earnings; do not make acquisitions that improve only current earnings per share, but those that are expected to contribute to long-term value. ● Carry only assets that maximize value; continually review assets and be prepared to sell units, brands, real estate, or other assets that can be sold for a price that is greater than their value to the company. ● Return cash to shareholders when there are no credible value-creating opportunities to invest in the business; through cash dividends and stock buybacks. ● Reward CEOs and other senior executives for delivering superior long-term returns. ● Reward operating unit managers for adding superior multiyear value. ● Reward middle managers and frontline employees for delivering superior performance on the key value drivers that they influence directly. ● Require senior executives to bear risks of ownership just as shareholders do. ● Provide investors with value relevant information. Required: A key topic in management accounting is the valuation of a company. Focusing on public companies, Rappaport explains how to increase business value to shareholders. Summarize his 10 recommendations and show how they can be related to cost management, management compensation, and business valuation.

Household Brands Inc. (HBI) manufactures household goods in the United States. The company made two acquisitions in previous years to diversify their product lines. In 2011, HBI acquired cosmetics and consumer electronics companies. HBI is now, in 2020, comprised of three divisions: cosmetics, household, and consumer electronics. The following information (in thousands of dollars) presents operating revenues, operating income, and invested assets of the company over the last three years: Revenue Operating Income Assets Cosmetics 2018 \ 24,500 \ 2,300 \ 10,000 2019 22,500 1,900 10,000 2020 19,600 1,800 9,500 Household 2018 17,400 1,300 7,500 2019 15,300 1,100 8,000 2020 12,500 900 6,500 Electronics 2018 13,500 1,500 4,500 2019 9,500 1,100 4,500 2020 8,700 1,050 4,300 Household Brands Total 2018 55,400 5,100 22,000 2019 47,300 4,100 22,500 2020 40,800 3,750 20,300 The current compensation package is an annual bonus award. The senior executives share in the bonus pool. The pool is calculated as 20% of the annual residual income of the company. The residual income is defined as operating income minus a cost of capital charge of 15% of invested assets. Round all calculations to two significant digits. Return on sales in the household division in 2019 is (rounded):

The King Mattress Company had the following operating results for 2018-2019. In addition, the company paid dividends in both 2018 and 2019 of $60,000 per year and made capital expenditures in both years of $30,000 per year. The company's stock price in 2018 was $8 and $7 in 2019. The industry average earnings multiple for the mattress industry was 9 in 2019 and the free cash flow and sales multiples were 18 and 1.5, respectively. The company is publicly owned and has 1,200,000 shares of outstanding stock at the end of 2019. $\text { Balance Sheet, Dec 31, }$ 2019 2018 Cash \ 340,000 \ 100,000 Accounts Receivable \ 350,000 \ 400,000 Inventory \ 250,000 \ 300,000 Total Current Assets \9 40,000 \8 00,000 Long-lived Assets 1,080,000 1,100,000 Total Assets \2 ,020,000 \1 ,900,000 Current Liabilities \2 00,000 \3 00,000 Long-term Debt 600,000 500,000 Shareholder Equity 1,220,000 1,100,000 Total Debt and Equity \2 ,020,000 \1 ,900,000 $\text { Income Statement, for year ended Dec } 31 \text {, }$ 2019 2018 Sales \ 4,750,000 \ 4,500,000 Cost of Sales 4,100,000 4,000,000 Gross Margin 650,000 500,000 Operating Expenses 350,000 400,000 Operating Income 300,000 100,000 Taxes 120,000 40,000 Net Income \1 80,000 \6 0,000 Cash Flow from Operations 2019 2018 Net Income \ 180,000 \ 60.000 Plus Depreciation Expense 50,000 50,000 + Decrease (-inc) in AccRec. and Inv. 100,000 - + Increase (-dec) in Cur. Liabl. (100,000) - Cash Flow from Operations \2 30,000 \1 10,000 The accounts receivable turnover ratio for 2019 is (rounded):

The Harrison Bicycle Company had the following operating results for 2018-2019. In addition, the company paid dividends in both 2018 and 2019 of $80,000 per year and made capital expenditures in both years of $230,000 per year. The company's stock price in 2018 was $14.20 and $12.50 in 2019. Also in 2019, the industry average earnings multiple for the bicycle industry was 8 and the free cash flow and sales multiples were 16 and 1.35, respectively. The company is publicly owned and has 1,400,000 shares of outstanding stock at the end of 2019. $\text { Balance Sheet, Dec 31, }$ 2019 2018 Cash \ 267,000 \ 100,000 Accounts Receivable \ 525,000 \ 400,000 Inventory \ 450,000 \ 300,000 Total Current Assets \ 1,242,000 \ 800,000 Long-lived Assets 1,205,000 1,100,000 Total Assets \2 ,447,000 \1 ,900,000 Current Liabilities \5 00,000 \5 00 Long-term Debt 600,000 500,000 Shareholder Equity 1,347,000 1,100,000 Total Debt and Equity \2 ,447,000 \1 ,900,000 $\text { Income Statement, for year ended Dec 31, }$ 2019 2018 Sales \ 6,250,000 \ 5,450,000 Cost of Sales 5,125,000 4,400,000 Gross Margin 1,125,000 1,050,000 Operating Expenses 580,000 550,000 Operating Income 545,000 500,000 Taxes 218,000 200,000 Net Income \3 27,000 \3 00,000 Cash Flow from Operations 2019 2018 Net Income \ 327,000 \ 300,000 Plus Depreciation Expense 125,000 125,000 + Decrease (-inc) in AccRec. and Inv. 7(275,000) - + Increase (-dec) in Cur. Liabl. 200,000 - Cash Flow from Operations \3 77,000 \4 25,000 \ $\quad$ The inventory turnover ratio for 2019 is (rounded):

Household Brands Inc. (HBI) manufactures household goods in the United States. The company made two acquisitions in previous years to diversify their product lines. In 2011, HBI acquired cosmetics and consumer electronics companies. HBI is now, in 2020, comprised of three divisions: cosmetics, household, and consumer electronics. The following information (in thousands of dollars) presents operating revenues, operating income, and invested assets of the company over the last three years: Revenue Operating Income Assets Cosmetics 2018 \ 24,500 \ 2,300 \ 10,000 2019 22,500 1,900 10,000 2020 19,600 1,800 9,500 Household 2018 17,400 1,300 7,500 2019 15,300 1,100 8,000 2020 12,500 900 6,500 Electronics 2018 13,500 1,500 4,500 2019 9,500 1,100 4,500 2020 8,700 1,050 4,300 Household Brands Total 2018 55,400 5,100 22,000 2019 47,300 4,100 22,500 2020 40,800 3,750 20,300 The current compensation package is an annual bonus award. The senior executives share in the bonus pool. The pool is calculated as 20% of the annual residual income of the company. The residual income is defined as operating income minus a cost of capital charge of 15% of invested assets. Round all calculations to two significant digits. The total amount of the bonus pool for 2018 is:

Any system of compensation:

As a firm's strategy changes to respond to different stages of a product's life cycle, compensation:

A current bonus can consist of:

All of the following are listed as common payment options for bonus compensation plans except:

The King Mattress Company had the following operating results for 2018-2019. In addition, the company paid dividends in both 2018 and 2019 of $60,000 per year and made capital expenditures in both years of $30,000 per year. The company's stock price in 2018 was $8 and $7 in 2019. The industry average earnings multiple for the mattress industry was 9 in 2019 and the free cash flow and sales multiples were 18 and 1.5, respectively. The company is publicly owned and has 1,200,000 shares of outstanding stock at the end of 2019. $\text { Balance Sheet, Dec 31, }$ 2019 2018 Cash \ 340,000 \ 100,000 Accounts Receivable \ 350,000 \ 400,000 Inventory \ 250,000 \ 300,000 Total Current Assets \9 40,000 \8 00,000 Long-lived Assets 1,080,000 1,100,000 Total Assets \2 ,020,000 \1 ,900,000 Current Liabilities \2 00,000 \3 00,000 Long-term Debt 600,000 500,000 Shareholder Equity 1,220,000 1,100,000 Total Debt and Equity \2 ,020,000 \1 ,900,000 $\text { Income Statement, for year ended Dec } 31 \text {, }$ 2019 2018 Sales \ 4,750,000 \ 4,500,000 Cost of Sales 4,100,000 4,000,000 Gross Margin 650,000 500,000 Operating Expenses 350,000 400,000 Operating Income 300,000 100,000 Taxes 120,000 40,000 Net Income \1 80,000 \6 0,000 Cash Flow from Operations 2019 2018 Net Income \ 180,000 \ 60.000 Plus Depreciation Expense 50,000 50,000 + Decrease (-inc) in AccRec. and Inv. 100,000 - + Increase (-dec) in Cur. Liabl. (100,000) - Cash Flow from Operations \2 30,000 \1 10,000 Return on equity for 2019 is (rounded):